International Monetary Fund

Cyprus and Europe's mounting malaise

March 27, 2013: 1:38 PM ET

Cyprus is more than the sad story of a small economy which allowed its banks to grow irresponsibly. It is also points to shifts in the determinants of European stability.

By Mohamed A. El-Erian

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FORTUNE -- Many are hoping that, after dominating the headlines for almost two weeks now, the tiny island of Cyprus will soon return to virtual obscurity in the global financial media. For this to happen, the latest country rescue package needs to hold. Yet prospects are highly uncertain -- confirming a gradual shift in power in Europe and fueling concerns for the wellbeing of other small European economies, as well as the broader economic and financial stability of the region.

As most readers know, officials from Europe and the IMF badly bungled the first attempt at rescuing Cyprus. Realizing the policy slippage, and after a rather unusual (and quite public) blame game, they scrambled and came up on Monday with a new package. While technically more plausible, it faces considerable implementation challenges.

The second rescue restored the usual safeguards enjoyed by insured bank deposits (i.e., those below EUR 100,000). It eschewed a rather blunt generalized approach to the banking system, opting instead for a more sensible entity-specific one. And it incorporated more common sense in allocating burden sharing on the capital structure, including imposing severe losses on bond holders and other senior creditors.

In light of the severity of the Cypriot situation, and given official creditors' hesitation to commit their taxpayers to another large financing, the new rescue involved another notable, and highly unusual feature -- that of very significant haircuts on uninsured bank deposits. Partial initial indications suggest that these could be as high as 80% for the most problematic bank, and 40% for another.

It is not unheard of for officials to need two rounds to rescue a country. Indeed, it was the case for several cases in the past, including Mexico in 1995 and Korea in 1999. What is unusual is that, this time around, the second round came so quickly after the first. The reasons for this speak to more than inadequate design, generalized bailout fatigue, and mounting coordination problems. They also highlight four areas of major uncertainties that warrant close monitoring.

The first test for the Cypriot rescue will come as soon as the government reopens the country's banks (currently scheduled for tomorrow). It is critical that this process be orderly, transparent and sustained. Put bluntly, the already shaky rescue package will not survive persistent images of bank runs and widening street protests.

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This speaks to the second uncertainty: whether the government is able to maintain a set of capital controls that dissuades people from pulling their money out of the country while at the same time, and this is critical, not totally choking an already-struggling economy via widespread shortages, hoarding, and black markets.

Well-functioning capital controls are difficult to design and implement. Importantly, the Cypriot government needs to convey that these controls are both temporary and reversible. And this is very hard to do when, being part of the single currency eurozone, it cannot depreciate its currency as a means of realigning price incentives and limiting the inevitable leakages that accompany capital controls.

Third, it is not clear how long it will take for some sense of normalcy to return to the functioning of the Cypriot economy. Today the country is paralyzed by much more than the immediate shock of the crisis. Under pressure from its European partners, it is in the process of permanently dismantling its status as an offshore banking center. Absent a new growth model and much greater external financial support -- both of which are unlikely to materialize quickly -- the economy risks falling into a protracted depression.

Finally, there are questions on how depositors will now behave in other vulnerable European countries, especially those with large uninsured accounts. Will they feel compelled to take cash out of banks now that Europe has broken all sorts of taboos?

Most analysts are rightly inclined to focus on the larger economies such as Italy and Spain. In doing so, they should also keep a keen eye on what would normally be regarded as the smaller "non-systemic" ones (particularly Slovenia and those with a large banking system relative to their national economies). History warns us that heightened instability in a handful of "non-systemics" can easily become systemic.

These four economic and financial uncertainties have notable socio-political dimensions. The longer they persist, the higher the risk that citizens would continue to lose trust in the traditional political order and established political parties -- thus reducing the scope for the effective implementation of reform programs and also increasing the risk of social disorder.

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Cyprus is more than the sad story of a small European economy which allowed its banks to grow excessively and irresponsibly. It is also an indicator of an important gradual shift in the major determinants of European stability -- away from the guiding hands of national governments, the European Commission, the European Central Bank, and the International Monetary Fund and to the less coordinated actions of increasingly frustrated and disillusioned citizens in a growing number of countries.

What is happening in Cyprus today is reminding citizens in other countries of an old saying: Fool me once, shame on you; fool me twice, shame on me.

To predict how Europe evolves from here, analysts need to broaden their focus well beyond the traditional national and multilateral power centers. Increasingly, the fate of a growing number of European economies rests in the hands of citizens who feel they have no choice but to self-insure financially, disconnect economically, and protest socially.

Mohamed A. El-Erian is the CEO and co-chief investment officer of PIMCO. He also chairs the U.S. president's global development council.

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